Let’s say you walk into a Japanese food festival, which is not a normal thing or something that you are used to, and the biggest question is what meal am I gonna pick? Well, the basic approach that you would take is that just walk around the food stalls observe which stalls the majority of the people are queuing to get their food, then see what they are serving before you make a choice. Based on your assumption and the crowd’s preference you decide to go to that particular vendor for your meal. Chances are that you could be eating the best tasting food available on the festival. So that’s basically what technical analysis is explained like to a 5th grade.
So in a more technical aspect, technical analysis is basically is that study of past market action in trying to measure what the market prices might be in the future or in other words the study of the price! Technical analysis from a trader’s POV is the study of historical data and chart, in order for traders to make better-educated trades.
Technical Analysis is a research technique that’s used to identify trading opportunities in the market based on the actions of market participants. The actions of markets participants can be visualized by means of a stock chart. Over time, patterns are formed within these charts and each pattern conveys a certain message. The job of an analyst or more specifically a technical analyst is to identify these patterns and develop a point of view.
Like any research technique, technical analysis stands on a bunch of assumptions. As a practitioner of technical analysis, you need to trade the markets keeping these assumptions in perspective. Of course, we will understand these assumptions in details as we proceed along.
Characteristics of Technical Analysis
1. The primary characteristic of a technical analysis involves employing models and trading rules depending on price and volume transformations, like moving averages, relative strength index, regressions, business cycles, inter-market and intra-market price correlations, stock market cycles, or through identification of chart patterns.
2. The second characteristic of technical analysis stands in comparison with the fundamental analysis approach to stock and security analysis. The technical analysis evaluates price, volume, and similar market info unlike fundamental analysis considering the facts of company, market, currency, or commodity.
3. Finally, technical analysis is used widely among traders and financial professionals and is frequently used by active day traders, pit traders, and market makers.
Principles of Technical Analysis
The basic principle of technical analysis is that the price of a market reflects all applicable info, thus making their analysis considering the history of the trading pattern of a security more willingly than external drivers like economic, fundamental, and news events… the key principles of technical analysis include:
1. Market action discounts everything – This assumption tells us that, all known and
unknown information in the public domain is reflected in the latest stock price. For example, there could be an insider in the company buying the company’s stock in large quantity in anticipation of a good quarterly earnings announcement. While he does this secretively, the price reacts to his actions thus revealing to the technical analyst that this could be a good buy.
2. Prices of a product move in trends – All major moves in the market is an outcome of a trend. The concept of the trend is the foundation of technical analysis. For example, the recent upward movement in the NYSE Index to 7700 from 6400 did not happen overnight. This move happened in a phased manner, in over 11 months. Another way to look at it is, once the trend is established, the price moves in the direction of the trend.
3. History tends to repeat itself – – In the technical analysis context, the price trend tends to repeat itself. This happens because the market participants consistently react to price movements in a remarkably similar way, each and every time the price moves in a certain direction. For example in up-trending markets, market participants get greedy and want to buy irrespective of the high price. Likewise in a downtrend, market participants want to sell irrespective of the low and unattractive prices. This human reaction ensures that the price history repeats itself.
Now that we had a close look at what Technical analysis let’s look where it could be applied:
The New York stock market is open from 9: 00 AM to 4:30 PM. During the 7 hours 30-minute market session, there are millions of trades that take place. Think about an individual stock – every minute there is a trade that gets executed on the exchange. The question is, as a market participant, do we need to keep track of all the different price points at which a trade is executed?
To illustrate this further, let us consider this imaginary stock in which there are many trades. Look at the picture below. Each point refers to a trade being executed at a particular time. If one manages to plot a graph which includes every second from 9: 00 AM to 4:30 PM, the graph will be cluttered with many points. Hence in the chart below, for ease of understating I’ve plotted a limited time scale period:
The market opened at 9:00 AM and closed at 4:30 PM during which there were many trades. It will be practically impossible to track all these different price points. In fact what one needs is a summary of the trading action and not really the details on all the different price points.
By tracking the Open, high, low and close we can draw a summary of the price Action.
* The open – When the markets open for trading, the first price at which a trade executes is called the opening Price.
* The high – This represents the highest price at which the market participants were willing to transact for the given day.
* The Low – This represents the lowest level at which the market participants were willing to transact for the given day.
* The close – The Close price is the most important price because it is the final price at which the market closed for a particular period of time. The close serves as an indicator for the intraday strength. If the close is higher than the open, then it is considered a positive day else negative.
* The closing price also shows the market sentiment and serves as a reference point for the next day’s trading. For these reasons, the closing price is more important than the Open, High or Low prices.
* The open, high, low, close prices are the main data points from the technical analysis perspective. Each of these prices has to be plotted on the chart and analyzed.
When you strip down to the basic the technical analysis is all about the study of demand and supply, it only focuses on market action. On the other hand, technical analysis is not the only approach used to analyzing stocks. If you understand the benefits and limitations of technical analysis, it can give you a new set of tools or skills that may help enable you to be a better trader or investor. Or living in the cloud age this analytics could be used much explicitly via data analytics tools such as Zepto, a tool integrated with AI and ML that would go a step further and show you what makes might look like in future or anomalies that your eyes could have missed.